Is It Time To Prepare For Economic Weakness?

Editor's note: Chris Ciovacco's seven part series will resume shortly.

Executive Summary:

Investors can do well in both good and bad economic times (see below).

The odds now highly favor a significant economic slowdown or a recession.

The NASDAQ has recently broken its 3.6 year uptrend.

Historically, stocks have not performed well in this seasonal period when
a U.S. President is at the midpoint of his term and elections are held
in the fall.

Interest rates will most likely go a little higher before declining during
economic weakness.

Using investments from several different asset classes, investors can do very
well even in bad times for the major U.S. stock indices and the economy. As
described below, the odds now heavily favor continued slowing of the economy
and lower stock prices in the next 60 to 90 days (maybe longer). Since the
markets are now trending lower, it is prudent to revisit how several asset
classes behaved during the last serious economic slowdown. The major U.S. stock
indices began their last sustained period of losses in early March of 2000.
This downtrend lasted until early October 2002.

Knowledge of the performance of several asset classes from March 10, 2000
to October 10, 2002 can help investors prepare for the next economic slowdown.
As many investors know, 2000 to 2002 was an extremely difficult time to invest.
Below are some helpful stats showing index returns or returns for specific
mutual funds. Mutual funds (names not shown) are used as a proxy for an asset
class:

Returns Mar 10, 2000 to Oct 10, 2002

Index or Proxy

Change

NASDAQ

-76.9%

S&P 500

-42.4%

DOW

-24.1%

Gold Bugs Index

66.5%

CRB Index (Commodities)

5.13%

Hedged U.S. Stock Fund

39.97%

Inter'l Real Estate Fund

7.4%

Long-Term U.S. Gov Bond Fund

40.4%

Short-Term U.S. Gov Bond Fund

39.3%

CBOE Gold Index

26.5%

Just as many of the asset classes above performed very well during the last
bear market, there will be asset classes that perform very well during any
future bearish periods. As we move forward, the performance from previous difficult
times can be used as a guide to help investors allocate their assets during
any future market weakness. Since many factors have changed since the period
from March 2000 to October of 2002, investors cannot blindly use the correlations
from that period today.

While investments should be made based on what is actually happening, it is
helpful to put the past correlations in the context of the current environment.

What are the markets and economic indicators telling us?

Many market watchers have been calling for economic weakness for well over
a year now. Based on experience, it is important to wait for the market to
confirm any forecast (positive or negative) rather than try to guess or time
when the current trend may change. As an example, many money managers have
missed substantial gains in the last 18 months while they based their allocations
solely on opinions or forecasts while ignoring the current market trend.

The NASDAQ still tends to lead other markets higher and it also tends to lead
the way on the downside. The NASDAQ may now be confirming that the economy
is headed for a serious soft patch or even a recession. After the dot.com bust,
which began in March of 2000, the NASDAQ finally found a bottom in October
of 2002. Since that time, the trend has been up. Based on recent declines,
the uptrend may now be broken, which is a signal to prepare for possible further
declines in all the major averages. The broken trend in the NASDAQ is easy
to see on the chart below:

Since the markets seem to be confirming the negative forecasts, it is prudent
to review some relationships between stocks, the Federal Funds Rate, the yield
curve, and leading economic indicators (LEIs). Here are some bits of information
that seem to be lining up with the recent poor performance in the major stock
averages:

Based on history going back to 1950 and the leading economic indicators
for the last six months, there is a 69% chance that we are heading into
a recession and a 100% chance of significant economic slowdown. This does
not mean a recession or slowdown is 100% certain. It just means that based
on the past, the odds are very high that a slowdown or recession is coming.
In all of the economic slowdowns, both long-term and short-term interest
rates moved lower, which means bonds have been a good place to be during
economic weakness. Keep in mind, it is probably too early to make any significant
moves into bonds. Rising rates are bad for bonds and the Fed is probably
not done yet.

When you add the current inverted yield curve to the recent leading economic
indicators, the chance of a recession increases to 85%. History says the
approximate time of the onset of the recession would be March of 2007.

The current shape of the yield curve also tells us that investors believe
the Fed will raise rates by an additional 50 basis points before they stop.
If you go back to the mid 1950s, the stock market on average peaks 3.5
months before the Fed stops raising rates. If we assume that May 5, 2006
was the peak for the S&P 500, history says that the Fed would finish
raising rates somewhere in August or September. The Fed meets on August
9th and September 20th. Therefore, it is possible that we get a 25 basis
point hike at both meetings. As of this writing, the markets are signaling
that at least one more rate increase is coming.

We are in the middle of Bush's second term and we have mid-term elections
coming up. On average during mid-term election years, the Dow declined
22% from its yearly high to the yearly low. Using the current year high
of 11,642 on the DOW, a drop of 22% would take us to 9,080 (or 15.5% below
current levels). The good news is that the average gain from that bottom
over the next two years is 50%. That would mean a high in the DOW of 13,620
in roughly two years (or 27% higher than today's level of 10,746).

With recent market weakness, seasonal factors, and economic indicators all
lining up in the bearish camp, it is prudent to review history and your current
asset allocation.

The comments in this article are based on market activity as of Tuesday, July
18, 2006 at noon EDT and are subject to change based on future market activity.

Chris Ciovacco is the Chief Investment Officer for Ciovacco
Capital Management, LLC. More on the web at www.ciovaccocapital.com.

All material presented herein is believed to be reliable
but we cannot attest to its accuracy. Investment recommendations may change
and readers are urged to check with their investment counselors and tax advisors
before making any investment decisions. Opinions expressed in these reports
may change without prior notice. This memorandum is based on information available
to the public. No representation is made that it is accurate or complete. This
memorandum is not an offer to buy or sell or a solicitation of an offer to
buy or sell the securities mentioned. The investments discussed or recommended
in this report may be unsuitable for investors depending on their specific
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subject to change without notice. This information is based on hypothetical
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Ciovacco Capital Management, LLC is an independent money
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